1/28/2009 @ 12:00AM

Swedish Banking Lessons

The big crisis, in the view of many, had its roots in the extensive deregulation of the financial sector and expansive monetary policies. The tax system favored borrowing and the loosening of credit markets led to a dramatic expansion in the stock of debt.

Equity prices and real estate prices increased sharply, rising more than 125% in the span of a few years–a full-fledged speculative bubble. Consumption increased sharply and private saving declined, becoming negative. There were sizable current account deficits. When the speculative bubble began to deflate it dealt a severe blow to the banking system.

Sound familiar? Of course–but this is a description of the financial crisis that hit Sweden in the 1990s. It was an important episode and a very difficult time for Sweden, which suffered a severe economic contraction a result.

Sweden is very different from the U.S.–our economy is huge, Sweden’s is small; what happens here has worldwide systemic effects, what happens in Sweden largely stays in Sweden. Nevertheless, there may be something to be learned from the way the Swedes dealt with the crisis.

The Swedish approach has been characterized in the press and the blogosphere as a nationalization of the banking system, and there is enthusiasm in some quarters for doing the same in the U.S. and UK.

Of course, nationalization is a loaded word and shouldn’t be used carelessly. In the Swedish case, it is not accurate to call what happened a “nationalization,” and it is worth knowing a few facts about what actually occurred and what the consequences were.

The six largest banks in Sweden accounted for nearly 90% of the market in the early 1990s. In the course of the crisis, these banks suffered huge loan losses amounting to close to 12% of GDP. Five of the six were in desperate need of new capital and confidence in the financial system was beginning to be seriously impaired.

In late 1992, following the failure of one bank, in an attempt to restore public confidence, the government announced a guarantee for the whole banking system that provided protection for creditors but none for shareholders.

The banks responded in different ways. Handlesbanken weathered the crisis without needing new capital. SE-banken and two others got minor assistance from the government but survived by raising new capital from their owners. The biggest problems were at two banks, Nordbanken and Gota. The government was the majority owner of the former, and the latter went bankrupt and was taken over by the state and merged into the former.

An important principal that was enforced at the outset was that the banks that needed direct help from the government were required to first meet losses with the capital provide by shareholders. Here, the government’s clearly stated motivation was to avoid creating more moral hazard than necessary.

They saved the banks but not the owners of the banks. This is lesson number one.

Once the banks were recapitalized with government money, the next step was to create a “bad bank” called Securum, which took over the riskier and nonperforming loans of Nordbanken and Gota.

Securum was managed as an independent company with the objective of disposing of its assets while minimizing the costs to taxpayers. Nordbanken was partially privatized in 1995 and Securum was dissolved at the end of 1997. Estimates are that the total net cost to taxpayers was about 2.1% of GDP.

Lesson number two: It is a good idea to get the bad assets off the books and manage them separately.

In the aftermath of the U.S. government’s Troubled Asset Relief Program debacle of last October, the commentariat beatified British Prime Minister Gordon Brown for showing us the way out of the crisis with his bold plan to inject capital into the banks directly rather than trying to buy troubled assets as Paulson initially proposed.

In TARP, The Sequel, we concocted our own version of Brown’s strategy that was a bit less bold and, importantly, tried very hard not to dilute the equity holders. But the banking crisis is back and, like a mutating virus, it is more dangerous than ever.

The U.K. is faced with a fiscal crisis, a banking crisis and rapidly falling currency all at once. In the U.S., we are continuing to provide both guarantees and new capital for the banking system. There are renewed discussions of returning to the original goals of TARP and putting together a mega bad bank called an aggregator bank.

In an earlier column I argued that the “good bank-bad bank” strategy adopted by the Swiss seemed better.
UBS
was able to shift the most troublesome assets from its balance sheet into a fund controlled by the Swiss National Bank (SNB), which was authorized to loan the fund up to $54 billion.

UBS contributed $6 billion of equity to the fund and sold it $60 billion of risky assets that had been marked to market. The SNB controls the fund and acquired the UBS equity stake for $1. The cash flow from the fund is used to pay off its loan. UBS also raised additional capital by selling convertible notes to the Swiss government. The original equity holders were severely diluted.

Like the Swedish approach, this plan has the advantage of removing the troubled assets from the balance sheet of the bank and recapitalizing it–as TARP 1 intended to do–and the ultimate cost to taxpayers depends on the value of the troubled assets in the long run. The advantage of isolating them in the fund is that they don’t have to be liquidated at fire-sale prices and can be sold in an orderly manner.

There is one final lesson to be learned from the Swedish experience. Once they realized the extent and systemic nature of their crisis, they acted decisively, with clarity and with thoughtful consideration of the fact that their actions could create substantial moral hazard and add to systemic risk if they didn’t adhere to certain common-sense principles. We have a lot to learn.

Thomas F. Cooley, the Paganelli-Bull professor of economics and Richard R. West dean of the NYU-Stern School of Business, writes a weekly column for Forbes.